S&P Gilded Gemstone With Top Grades as U.S. Mortgages Crumbled

Standard & Poor’s stamped 72 percent of a $1.04 billion collateralized debt obligation called Gemstone VII issued in February 2007 with AAA grades, granting
the debt the same gilded credit rating it bestowed on the U.S. government at the time. Photographer: Michael Nagle/Bloomberg

Feb. 7 (Bloomberg) -- Standard & Poor’s stamped 72 percent
of a $1.04 billion collateralized debt obligation called
Gemstone VII issued in February 2007 with AAA grades, granting
the debt the same gilded credit rating it bestowed on the U.S.
government at the time.

The ratings company confirmed the ranking the next month,
even after the deal’s prospectus warned of “risks of losses”
in the securities.

Gemstone defaulted in April 2008.

The CDO, issued by Deutsche Bank AG and composed primarily
of subprime mortgage-backed securities, is one of the deals the
Justice Department named in its Feb. 4 lawsuit accusing the
world’s largest credit-rater of deliberately understating the
risks of mortgage bonds to win business from Wall Street banks.

“Keep your fingers crossed but I think we will price this
just before the market falls off a cliff,” Michael Lamont, the
co-head of Deutsche Bank’s CDO group at the time, said in a Feb.
8, 2007 e-mail regarding the Gemstone transaction, cited in a
report released by the U.S. Senate’s Permanent Subcommittee on
Investigations in April 2011.

The fate of Gemstone underscores the role the rating
companies played in enabling lenders to offload risky mortgages
even as the housing market showed signs of imploding. The U.S.
is seeking penalties against S&P and its New York-based parent,
McGraw-Hill Cos. that may amount to more than $5 billion, based
on losses suffered by federally insured banks.

Saddling Investors

The Gemstone transaction saddled its investors, including
M&T Bank Corp., Wachovia Corp., Commerzbank AG and Standard
Chartered Plc, with “losses in the billions of dollars,”
according to a lawsuit filed in New York State court
against units of Deutsche Bank and HBK Investments LP in
September 2008. The suit didn’t accuse the rating companies of
any wrongdoing.

Deutsche Bank was able to sell $700 million of the
securities, which lost most of their value within 17 months,
according to the Senate report.

In July 2007, S&P downgraded more than 22 percent of the
subprime collateral backing the deal, according to the Justice
Department’s complaint.

S&P contests the allegations. Despite its best efforts to
“keep up with an unprecedented, rapidly changing and
increasingly volatile environment,” the severity of “what
ultimately occurred was greater than we -- and virtually
everyone else -- predicted,” the company said in a Feb. 4
statement.

Deal documents distributed by Deutsche Bank to Gemstone
investors at the time of the sale reveal concerns that the U.S.
housing market was headed for a precipitous fall.

Losses Risk

The document lists numerous contributors to stress in the
mortgage market, including declining property values and the
failure of mortgage lenders to “apply adequate standards to
potential borrowers.” Lax underwriting encompassed everything
from neglecting to verify buyers’ employment and income
histories, property values and not complying with predatory
lending statutes, according to the prospectus.

S&P confirmed its rating on the Gemstone CDO in March 2007,
according to the Justice Department’s complaint.

‘Raw Form’

David Tesher, head of one of S&P’s CDO groups, had told
colleagues in March that the firm should expect a rush in
business partly because some investors might have already signed
up for the deals, according to the complaint. Even if the CDOs
never were sold, he said, banks were better off creating them
rather than holding the underlying securities in “raw form”
because write-downs would be smaller.

Some financial institutions won’t purchase securities that
don’t carry investment-grade rankings, the complaint states,
leaving these investors reliant on S&P and its largest
competitor, Moody’s Investors Service, to judge the relative
creditworthiness of different securities. S&P, aware of its sway
over such institutions, knowingly “devised, participated in,
and executed a scheme to defraud investors,” according to the
complaint.

The lawsuit also cited deals including Octonian I,
Pampelonne CDO II, and Corona Borealis CDO Ltd. S&P said in its
statement that all of the CDOs cited by the Justice Department
received the same ratings from a competitor. Moody’s gave
Gemstone the same grades, according to data compiled by
Bloomberg.

CDOs are pools of assets such as mortgage bonds packaged
into new securities in which payments on the underlying bonds or
loans are used to pay investors.

Downgrade Warning

S&P rated U.S. Treasuries AAA before dropping them one
grade to AA+ on Aug. 5, 2011, citing political and financial
uncertainty related to the nation’s deficit and debt. Moody’s
has retained its top ranking for the securities, while warning
that a downgrade might be warranted in the future.

The September 2008 suit brought by M&T Bank states that the
Gemstone deal was “marketed with an overwhelming emphasis on
the S&P and Moody’s ratings of the notes and the representations
of safety and low risk conveyed by those writings.”

The parties agreed to end the case in January 2012 without
saying why, court records show.

The Justice Department case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Los
Angeles).